CFO Incentives Post-SOX

In our forthcoming Journal of Accounting Research paper, CFO Fiduciary Responsibilities and Annual Bonus Incentives, we examine how firms evaluate and compensate their CFOs. In addition to participating in decision making much like other senior executives, CFOs also have fiduciary responsibilities for reporting firms’ financial results and safeguarding the integrity of financial reporting. Although other top executives have fiduciary responsibilities for financial reporting as well, CFOs typically have more of an expertise and capacity to determine what numbers get reported. Responsibility for financial reporting raises the question of whether it is appropriate to reward CFOs bonuses contingent on financial performance that is effectively self-reported.

To provide a framework to understand why CFO compensation is tied specifically to financial performance, our paper presents an agency model with two executives, a CEO focused on production and a CFO entrusted with dual responsibilities. Our model generates two insights that have implications for changes in CFO compensation practices in the post Sarbanes-Oxley (SOX) environment. First, we find that if CFOs personally bear greater misreporting costs, then firms offer their CFOs steeper incentives tied to financial performance. The intuition is straightforward; if CFOs are more conscientious in discharging their fiduciary duties, then firms are more comfortable offering steeper incentives since rewards for reported performance are less susceptible to unwarranted overpayments. Second, we find that as misreporting becomes more costly, firms are less willing to tolerate misreporting. Hence, firms offer their CFOs weaker incentives tied to financial performance to expressly motivate them to focus more on their fiduciary duties.

We rely on a proprietary survey of CFO performance evaluation and compensation practices of public and private firms to conduct our empirical tests. Since public firms were affected by SOX much more than private firms, the public versus private distinction allows for an identification strategy of the SOX-effect on CFO compensation that has not been feasible in prior literature. Our survey was sent to approximately 30,000 members of the American Institute of Certified Public Accountants who are CFOs, CEOs, or other executives informed about CFO and CEO compensation. We received 1,353 responses from both public and private entities.

Our data indicates that annual bonuses are by far the most common incentive component of CFO compensation plans and that, on average, about 50 percent of the CFO bonus is based on accounting-based financial performance. In addition, the extent to which CEO and CFO incentives are tied to financial performance are highly correlated. More importantly, we find that from 2003 to 2007 public entities (relative to private entities) lowered the percentage of CFO bonuses contingent on financial performance. Specifically, we compare the bonus weight on financial performance measures that is expected in 2007 with the actual bonus weight in 2003 (indicative of incentives in the pre-SOX environment) and find marked differences for public versus private entities. For example, predicted values from one of our regressions suggest that public companies (with median sample characteristics) lowered the percentage of their CFO’s bonus that depends on financial performance by about six percent while comparable private companies with similar characteristics increased the percentage by about three percent. We interpret this result as evidence that firms mitigate earnings management or other misreporting practices in part by deemphasizing CFO incentive compensation.

The full paper is available for download here.